Newspaper article Sarasota Herald Tribune

Should You Avoid All 'Junk' Bonds?

Newspaper article Sarasota Herald Tribune

Should You Avoid All 'Junk' Bonds?

Article excerpt

THE RATIONAL INVESTOR

In their search for income, many investors have stumbled across "junk bonds," also known as "high-yield bonds." Bonds are rated for safety, for example by Standard & Poor's, from AAA to D. Those rated BB+ or lower are called junk or high-yield. These tend to have default rates much higher than investment-grade bonds.

Junk bonds are never appropriate for any but the most aggressive investors. The question is: In the current investing environment, are they appropriate even for them? To better understand why we need to ask this, let's consider why investors buy investment-grade bonds: to provide more reliable income than from dividends or capital gains; to provide liquidity since these bond prices are more stable than stock prices; to lower overall portfolio volatility. They are not bought to generate high returns.

High-yield bonds do the opposite. Their income is not totally reliable because they default at higher rates than investment-grade bonds. They trade more like stocks than like investment-grade bonds, so they may not provide the needed liquidity. They don't help dampen portfolio volatility because they are highly correlated with stocks. Their main interest to investors is they can generate higher returns.

The key issue for aggressive investors is whether the extra interest they pay over equivalent-maturity U.S. Treasury bonds (the spread) is large enough to cover principal lost to defaults. Recently, the spread has been close to 5 percentage points, around the historical median of 5.11 percentage points.

Recently, U.S. junk-bond default rates have climbed to 5.5 percent and are likely to be over 6 percent by 2017. The historical median default-rate is 3.9 percent. However, commodity company junk bonds are seeing higher default rates. Global junk-bond default rates are 4.7 percent, about .5 percentage points above the long- term average. …

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